When Measuring Big Banks' Subsidy, First Count the Costs

Since the onset of the financial crisis, lawmakers and industry observers have debated the implicit funding subsidy that large financial institutions may receive because they are considered to be too big to fail. Over the last year, different groups have produced widelydivergentestimates of the existence and size of any subsidy, joining a long list of academic work on the subject that has also failed to yield a consensus.

At the request of Congress, the Government Accountability Office is about to weigh in on this subject this week. A key question remains: will GAO take into account the impact of the legislative and regulatory changes that have occurred since the passage of the Dodd-Frank Act?

The current debate has used the term 'subsidy' to describe the existence and size of a funding advantage enjoyed by large banks as a result of a market perception that they might be bailed out by the government in times of crisis. The estimates discussed in this debate typically refer to the lower rates that large banks have to pay on the bonds they issue or on the deposits they hold. This is an indirect 'cost of funding advantage,' rather than the type of direct government cash support usually conjured up by the term 'subsidy.

The existence of a cost of funding advantage is an important question. If the creditors of the largest banks believe that a government backstop exists, they will be less sensitive to risk and provide those institutions with funds at lower rates. This reduction of market discipline may provide incentives for the largest banks to engage in excessive risk-taking or increase their market share. Smaller institutions may then be tempted to increase their risk exposure in order to remain competitive. A large, persistent cost of funding advantage would make the financial system more concentrated and potentially less stable.

During the financial crisis, the government intervened in the financial system on an unprecedented scale. This was the era in which there was a clear and direct support for big banks. Indeed, all recent studies of the cost of funding during this period have found that the largest banks enjoyed significant advantages relative to smaller institutions. That should be no surprise.

But time has marched on, and many funding estimates have been based on outdated data that precedes the passage and implementation of key elements of Dodd-Frank. That omission makes a big difference, because Dodd-Frank and other post-crisis reforms have fundamentally reshaped the landscape.

Enhanced prudential standards for large banks are designed to create safer and sounder institutions. The panoply of still-to-be-completed supplemental rules on capital, leverage, liquidity and long-term debt for the largest institutions have the potential to reduce the risk of failure while ensuring that any losses that occur are absorbed by equity and debt holders, not taxpayers. Similarly, the orderly liquidation authority in Dodd-Frank, which the Federal Deposit Insurance Corp. is implementing through its single-point-of-entry strategy, provides a viable framework for resolving large, complex and interconnected institutions without the need for taxpayer support.

These rules have the potential to reduce the risk of systemic and institutional failure on the one hand, while ensuring that the costs of any failure will be borne by equity and debt holders, not taxpayers. If they work as intended, market perceptions of future government support should decline, perhaps substantially, over time, thereby reducing or eliminating any funding advantage. Indeed, Treasury Secretary Jack Lew, reflecting on the impact of these efforts, recently testified that the funding advantage for the biggest banks "is certainly shrinking if not gone."

When considered in the aggregate, it is not clear that the net effect of federal government intervention has been positive for large banks. Dodd-Frank imposed significant additional regulatory costs on the very largest institutions that also need to be considered. These costs may well equal, or even exceed, any funding benefits that these institutions might still derive from market perceptions of a government backstop. It is insufficient to simply focus on one side of the scale — the cost of private-sector funding — without examining the other side of a scale.

Numbers are meaningless without context. For example, getting 3 out of 10 questions right on an exam is an F. But in baseball, 3 hits in 10 at bats is an All-Star level performance.

Likewise, estimates of a funding advantage for large banks need to take into account the full measure of the post-Dodd-Frank legislative and regulatory response. Studies need to account for the impact of all the policy changes put in place after the crisis, as well as the regulatory regime that goes with them. With that broader view, hopefully the debate can shift back towards a conversation about the hard work of making financial reform more effective, boosting economic growth and protecting consumers.

Aaron Klein was deputy assistant secretary of the Treasury for economic policy from 2009-2012 and is currently Director of the Bipartisan Policy Center's Financial Regulatory Reform Initiative. Dr. Peter Ryan is a Policy Analyst at the Bipartisan Policy Center's Financial Regulatory Reform Initiative.

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Comments (2)

TBTF is a business model. It is a business model with enormous negative externalities that cannot be internalized by the few TBTF firms.

Regulatory measures imposed on the TBTFs are just a desperate attempt to minimize the impact on the economy of the TBTFs' imploding...impacts such as we experienced in the Great Recession.

To discount the TBTF subsidy by the cost of their regulation is to give them a credit for the dangerous business model they have chosen. Give credit where credit is due but not to firms that threaten the financial system.

Posted by hurley | Monday, July 28 2014 at 1:55PM ET

Dodd Frank has cost every banker more money, and as a percent of assets, I venture that it is higher for smaller banks than it is for larger ones. But it certainly should be part of the calculation of the value of the subsidy.

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